Rule Number One: Never Lose Money

When in school, I used to participate in our annual 6-KM cross-country race. Just the idea of “running away from school” was exciting for me, and thus I participated every year. And every year, there was this classmate of mine, Anshul, who won the race, beating all of us by at least half a kilometer and more.

While I did not look much into the reason then why Anshul was consistently winning the race every year, I now know why it was so.

Here is the speed chart of me and most of my other friends vs Anshul running that 6-KM race –

You know the reason now, don’t you?

The reason why we lost and Anshul won every year was because we focused on high speed alone, while he focused on consistency at a decent speed. In other words, while we were the Shahid Afridis of those races, Anshul was Rahul Dravid…and that made all the difference in the end.

Speed Vs Consistency
“Speed has never killed anyone. Suddenly becoming stationary, that’s what gets you,” said Jeremy Clarson, an English broadcaster, journalist and writer who specialises in motoring.

Consider investing. Every bull market creates a lot of new investors with 40-50% 5-year CAGR under then belts. And these people inspire others into making such kind of killing from stocks. Some of these guys are really smart, while most are just a product of the bull market.

So, a lot of new investors, who like I did at my school race, get inspired by others making fast returns in quick time and start the investing game at high speeds. And thanks to the bull market and beginner’s luck, they do make some good returns in the first 2-3 years of their career.

The going looks very easy, and the future looks very bright for these investors. And this causes them to raise their bets, and try things like –

Overpaying (not paying up, but overpaying) for high quality stocks because “the story remains exciting” and in the hope these stocks will continue to rise like they have done in the past (your long term returns are dependent on the price you pay for a business, and the probability of losing money by overpaying for stocks is high)

Buying low-quality businesses with mediocre or low return on capital (mistake) that appear cheap, and holding on when these stocks fall so as to get their money back (bigger mistake), and averaging as these stocks fall further (even bigger mistake).

Moving outside their circle of competence and buying businesses they don’t understand but just because a few others have recently made money in them (surprisingly, I suddenly see a lot of people wanting to learn about the pharma business now, seemingly because some of these stocks have done very well in the recent past).

Changing their investment philosophy abruptly to go with the flavour of the season (like I see some people now seeking comfort in buying average or bad businesses that are trading cheaply because they have nothing to buy among good businesses that are trading expensive)

Blindly cloning investors who have been successful in the recent past, ignoring that those cloned may have not seen more than one bad cycle and that some of them could be talking up their books

Here is a chart I would like to share on how most of these investors – who choose speed over consistency – fare when the race is run over a long distance (not 3-5 years but 15-20 years or more) –

This brings me back to the two basic rules of compounding –

The longer you let it work, the bigger will be its effect – time, not rate of return, is the most important variable in the compounding formula; and

If you lose big money even few times in your compounding journey, you will not receive its benefits, even in the long run.

So, like Clarson said, it’s not chasing the 25% CAGR speed that will kill you in the stock market, but the speed bumps you will meet along the way (losing big money, thanks to the mistake you may make in your need for high returns) that will get you.

Losing a 6-km race in school is still fine because the stakes are not high. But losing your wealth permanently can be disastrous because here your financial future is concerned. And once you trip over badly (due to the need for speed and the missteps it can lead you to take), it can be really difficult to come back into this game.

This, I believe, is why the most important words ever spoken in investing were – “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

And to modify this a bit – “Never lose money. But if you still lose some money out of your mistakes, never lose the lesson.”

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Comments

I would like to ask a question that for over a long term, according to you what is the best ROR a person should keep in mind, like I have read somewhere that, “if you are aiming for & getting Returns greater then Inflation then you are doing fine.” Is that holds good? or One must look for Investments that can compound @ 20% ROR or more? like that?

Thanks Gurpreet! While there is not any “best” rate of return that I can mention, earning comfortably above the inflation is what one should aim at. So, any return around 18-20% p.a. is what can be worked on. Regards.

But how do you avoid a -50% fall in your portfolio when there is a 2008 like market crash? Either you’ll have to anticipate it and sell all your equity before the crash, which is next to impossible or you’ll have to hold on to it until it recovers so that the long term is 15% even though you lost 50% on paper that year.

That’s the point Samir. You cannot prevent such external forces on your compounding journey. But the problem is when people add on to such external forces their own mistakes. So, while such crises will strike from time to time, it’s important to work towards minimizing own mistakes and avoid chasing large, quick returns. Regards.

Dear Vishal
Blindly following rule 1, would mean holding to a’ mistake’, and not selling at a loss. However, your modified rule is far more pragmatic and implementable in all situations.
Buying a good business within your circle of competence, at reasonable valuations and allowing it to to compound over time is the only mantra- for a successful investor. It is a marathon and not a 100 metre sprint. Easier said than done!!

Does the second part of the above saying, refers to getting out of scene from investing after a short stint of excitement/ returns or other way round that not looking back to market after you have suffered a loss..

My Rule 1 : 99.9% of the people can’t beat the FD/Debt returns
My Rule 2 : Stick to FDs/Debt Funds
When big shot PMS guys (full time into investing, authors, professors, seasoned investors, Stock advisors) like Pabrai and Porinju could lose so much capital, ordinary souls like us are nothing. The problem is every one thinks he is part of 0.1% as like every lottery buyer.